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Actively managed ETFs may be the biggest story that never quite happened in 2012. But thanks to a significant regulatory change and moves by three of the biggest fund firms, the playing field is about to change dramatically.

Exchange-traded funds saw record inflows of $191 billion in 2012, bringing the industry's assets under management to $1.4 trillion. But less than 1% of that, $10.5 billion, is in actively run ETFs, which were supposed to be The Next Big Thing.

Actively managed ETFs have faced a few big challenges. For starters, many active managers were skeptical of their transparency -- other investors would be able to see every move they make, almost in real time. Plus, many active managers use derivatives to control the risk and cash flow of their funds, a practice that the Securities and Exchange Commission banned for two and a half years.

Fidelity may be late to the ETF race, but it's already off and running. Don't count it out yet.
Ryan Snook for Barron's

The past few weeks have brought new developments with the potential to shake things up. First, in early December, the SEC lifted its moratorium on derivative use. Less than a week later, Fidelity Investments filed for permission to launch its own actively managed ETFs. Its first offering is slated to be a corporate-bond fund, although it's widely expected to pave the way for a lineup of ETFs run by active stockpickers. Then, on Jan. 2, T. Rowe Price won approval for its own active ETFs.

BOTH T. ROWE AND FIDELITY have what it takes to shake up the ETF industry, as does Franklin Templeton, which also has filed for approval. But top competitors have been watching Fidelity. Despite the crowding of the ETF market, sheer size and distribution can hugely help a latecomer, and Fidelity has both in spades. That worked for Charles Schwab and Pimco, which built fast-growing ETF businesses managing a combined $18 billion, even though their oldest products are barely three years old. "Everybody keeps a close eye on Fidelity," says one executive.

It seems that Fidelity has kept a close eye on others, too. The actively managed ETF world is dominated by just three funds, two of them from Pimco. One is
Pimco Enhanced Short Maturity,
mint 0.009894132779261898%PIMCO Enhanced Short Maturity Active ETFU.S.: NYSE Arca101.08
0.010.009894132779261898%
/Date(1425419997456-0600)/
Volume (Delayed 15m)
:
312298AFTER HOURS101.08
%
Volume (Delayed 15m)
:
1
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
0.6648199445983379% Rev. per Employee
N/AMore quote details and news »mintinYour ValueYour ChangeShort position
better known by its ticker, MINT, with $2.2 billion in assets, often used as an alternative to money-market funds. The other, also better known by its ticker, BOND, is an ETF iteration of Pimco's flagship Total Return mutual fund. BOND, launched in March, already has $3.9 billion in assets. The third is $1.6 billion
WisdomTree Emerging Markets Local Debteld -0.3351647811600043%Wisdom Tree Emerging Markets Local Debt FundU.S.: NYSE Arca40.56
-0.1364-0.3351647811600043%
/Date(1425419957571-0600)/
Volume (Delayed 15m)
:
23877AFTER HOURS40.58
0.0199999999999960.04930966469428008%
Volume (Delayed 15m)
:
2
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
5.325443786982248% Rev. per Employee
N/AMore quote details and news »eldinYour ValueYour ChangeShort position
(ELD). Notice the trend: All three are in the bond market, Fidelity's entry point, as well.

Bond managers have had an easier time with the transparency of ETFs: Bill Gross is tough to front-run when his
Pimco Total Returnbond -0.11905852184265958%PIMCO Total Return Active ETFU.S.: NYSE Arca109.06
-0.13-0.11905852184265958%
/Date(1425420000258-0600)/
Volume (Delayed 15m)
:
108830AFTER HOURS109.06
%
Volume (Delayed 15m)
:
4
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
3.9666238767650834% Rev. per Employee
N/AMore quote details and news »bondinYour ValueYour ChangeShort position
ETF has more than 700 positions. In contrast, a stockpicker with 50 or 100 holdings risks tipping off the market with big buys and sells. Firms like BlackRock have tried to persuade regulators to allow ETFs to mask more of their buying and selling, to no avail. A T. Rowe spokesperson says the firm is particularly cautious on this issue, and won't launch an ETF that can be easily front-run.

Jim Lowell, editor of the Fidelity Investor newsletter, expects the firm to launch both active and passive ETFs. He views the company's 40 or so select-sector mutual funds (which are actively managed), and the Fidelity enhanced index funds, as ripe for ETF cloning.

"They owned the sector business 15 years ago," says Dan Dolan, an ex–Merrill Lynch executive who helped steal the mantle from Fidelity by building what is today a better-known business: the $51 billion Select Sector SPDR funds. Those products, owned by State Street and distributed by Dolan's firm ALPS Distributors, are based on the sectors of the Standard & Poor's 500, making them one of the groups that could see heightened competition from Fidelity.

The Bottom Line

The $1.4 trillion exchange-traded-fund business is still in its infancy when it comes to actively managed ETFs. But expect to see growth in that area this year, led by Fidelity.

Dolan thinks Fidelity's active ETFs would charge less than the 1% that's typical of mutual funds, but more than the 0.18% SPDR average. Pimco already has shown how to do this without destroying existing mutual funds. The Pimco Total Return ETF's 0.55% expense ratio is in between the institutional-class shares of the flagship mutual fund, which charges 0.46%, and the less widely owned retail shares of the mutual fund, which cost 0.85%.

Fidelity has let the rest of the industry wonder what it's up to. The firm has hived off much of its activity in a new unit based in Colorado, after luring exchange-traded fund veteran Tony Rochte from State Street last year to run the operation, temporarily (a Fidelity spokesperson insists) called SelectCo. Fidelity declined to let Barron's interview Rochte, and a spokesman shed little light on plans. The decision to build in Colorado struck some observers as a curiosity for Fidelity's insular corporate culture, but the reticence has not. "Fidelity rarely leads with a bang," says Lowell. "It likes to go quietly and build."